Role of Informal Legal Institutions in Economic Development

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ESSAY
THE ROLE OF INFORMAL

LEGAL INSTITUTIONS IN
ECONOMIC DEVELOPMENT
Kevin J. Fandl, Esq.*
INTRODUCTION
Substantial mention has been made in the development
community of the importance of establishing and strengthening
property rights, enforcing contracts, streamlining business regis-
tration, and providing legal security for transactions between in-
dividuals and small businesses. These reform efforts have com-
monly been associated with the rule of law movement. It ap-
pears clear that such reforms are valuable as an economic
development tool, and that investments should be made to pro-
cure them.1 In fact, according to some authors, formal property
rights and contract enforcement may even be a prerequisite to
economic growth.2
What is not as clear, in economic circles at least, is the un-
derlying enforceability of such rights and the law upon which
they are based. Property rights, contract enforcement, and busi-
ness regulation are all legal concepts that require positive and
effective law at their foundation. Without the legal enforceabil-
* Adjunct Professor of Law, American University Washington College of Law; Asso-

ciate Legal Advisor, U.S. Immigration and Customs Enforcement; admitted to practice
in New York, Massachusetts, and Washington, D.C.; Doctoral candidate in Public Policy
at George Mason University; J.D., American University Washington College of Law;
M.A., American University School of International Service; B.A., Lock Haven University;
Fulbright Scholar. I would like to thank Dr. Ken Reinert for his comments and advice
on this piece, as well as the Fordham International Law Journal staff for their dedication
and diligent work to further develop the piece. I would also like to thank my wife
Monica and daughter Isabella for their eternal patience and support in this pursuit of
justice and equality under law.
1. But see Kevin E. Davis & Michael J. Trebilcock, The Relationship Between Law and
Development: Optimists versus Skeptics, 57 AM. J. COMP. L. (forthcoming 2009), available at
http://ssrn.com/abstract=1124045 (noting that the use of law as a development tool
has been criticized as having a weak link to economic development).
2. See, e.g., HERNANDO DE SOTO, THE MYSTERY OF CAPITAL: WHY CAPITALISM TRI-
UMPHS IN THE WEST AND FAILS EVERYWHERE ELSE 159 (2000) [hereinafter MYSTERY OF
CAPITAL].
Electronic copy available at: http://ssrn.com/abstract=1144643

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2 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1
ity of such rights, there is no practical value in having title to

property or a formal contract. As Hernando de Soto pointed
out with respect to property, land is useless without an accompa-
nying title showing ownership.3 Rights and the enforceability of
those rights set the foundation for effective exchange, invest-
ment incentive, and economic stability. Accordingly, to make
the concepts of property, contract, and business rights useful, a
body of law must underlie their implementation.
Economists have long asserted the central role of the state
and the individual economic transactions taking place within the
state for economic growth.4 Yet despite the efforts made by
many developing states to expand the role of the state and facili-
tate market transactions, the stark economic growth distinction
between developed and developing countries is growing.5 The
role played by institutions, while considered by early economists,
has recently been suggested as the missing element in market-
based economic growth theory.6 Institutions have been defined
as “the rules of the game [in a society or] the humanly devised
constraints that shape human interaction.”7 These constraints
have the potential to reduce transaction costs by facilitating trust
and security. With strong institutions, individuals are more likely
to take risks, trade freely, and invest in their assets. The result-
ing contribution to the economy can be beneficial to domestic
economic growth.
Law serves as an effective institution by this definition, pro-
viding a set of humanly devised incentives and constraints that
shape transactions. Law provides a set of rules designed to pro-
tect individuals, facilitate transactions between parties, and pro-
mote economic development by reducing transaction costs be-
tween individuals and firms. Accordingly, law has been promul-
gated as a means to repair the institutional gap in developing
countries and place them squarely on the road to economic
growth.
3. Id. at 6.
4. See, e.g., id. at 159.
5. See id. at 4-5, 69-72.
6. See generally David M. Trubek, The “Rule of Law” in Development Assistance: Past,
Present, and Future, in THE NEW LAW AND ECONOMIC DEVELOPMENT: A CRITICAL AP-
PRAISAL 74-94 (David M. Trubek & Alvaro Santos eds., 2006).
7. Douglass C. North, Economic Performance Through Time: The Limits to
Knowledge, Nobel Prize Lecture 2 (Dec. 9, 1993), available at http://nobelprize.org/
nobel_prizes/economics/laureates/1993/north-lecture.html.
Electronic copy available at: http://ssrn.com/abstract=1144643

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 3
When we begin to examine how legal reform can be pro-

vided to all people in a developing country, we run up against a
significant issue that is often sidestepped—informality. The ma-
jority of people that would be affected by land titling programs,
enhanced judicial access, or even the ability to draft formally en-
forceable contracts, operate outside the formal system of law and
thus are found in what the International Labour Organisation
(“ILO”) and many others have called the informal economy.8 As
such, these individuals have little if any access to formal legal
institutions, nor any evidence to support claims to property
rights or legal persona to defend against contract breach.9 The
scope of this segment of the economy is growing in size and im-
portance to economic development.10 According to the ILO:
Concerns with the global job crisis, with the decline in the
employment content of growth and the low quality of jobs
created, on the one hand, and with changing patterns of
work under the new production strategies in the global econ-
omy, on the other, are giving new momentum to the informal
economy debate in policy discussions, in developing and in-
dustrialized countries.11
Regardless of this lack of formal access, however, individuals
in the informal economy have been able to operate outside the
formal legal system, outside the formal economy, and seemingly
without a need for formal judicial enforcement or recognition of
rights, for many years.12 What some in the development commu-
nity have begun to recognize is that these individuals are in fact
operating under a very similar set of institutional protections,
what we will refer to here as informal legal institutions.
Some economists have contended that the institutions of
most relevance to development are economic institutions, which
they assert are conducive to protecting property rights and allo-
cating resources.13 “Societies with economic institutions that fa-
cilitate and encourage factor accumulation, innovation and the
8. International Labour Organisation, Committee on Employment and Social Policy Re-

port, ILO Doc. GB.298/ESP/4 (Mar. 2007) [hereinafter ILO Committee Report].
9. INTERNATIONAL LABOUR OFFICE, REPORT VI: DECENT WORK AND THE INFORMAL
ECONOMY 3 (International Labour Conference 90th Session 2002) [hereinafter ILO RE-
PORT VI].
10. See id. at 1.
11. ILO Committee Report, supra note 8, at 2.
12. See ILO REPORT VI, supra note 9, at 3.
13. See, e.g., Daron Acemoglu, Simon Johnson & James Robinson, Institutions as the
efficient allocation of resources will prosper.”14 While economic

institutions are indeed central to development, the fact that a
substantial portion of the economy operates outside of formal
legal and economic constraints makes the role of factor accumu-
lation and innovation subservient to legal protection. The insti-
tutions that facilitate and protect property, capital, and labor,
are legal institutions, and the driving force behind innovation is
intellectual property protection, which is also grounded in legal
institutions. Accordingly, the role of legal institutions, formal
and informal, may in fact be the primary driver of development
within a neo-institutional framework.
This Essay, then, will examine what informal legal institu-
tions are, whether or not they are effective for individuals in de-
veloping countries as a development tool, and the potential les-
sons that we can learn from their broad use and applicability.
I. INFORMAL RIGHTS
A. Defining the Informal Economy
In order to begin the examination of informal legal systems,
we must briefly define the nature of the informal economy. In-
formality arises in economic and legal discussions in two princi-
pal cases—informal labor and informal property. Each will be
discussed below.
While not the first to identify informality in general,15 infor-
mal property as a concept in economic development was high-
lighted by Hernando de Soto in his seminal work on the infor-
mal economy, The Other Path.16 Therein, de Soto suggested that
the lack of individual property titles and formal state registration
processes in many developing countries was causing a significant
drain on economic progress.17 His argument was that the legal
and administrative difficulties in registering property (and busi-
nesses) left many individuals without an ability to secure credit
Fundamental Cause of Long-Run Growth, in HANDBOOK OF ECONOMIC GROWTH 1 (Philippe

Aghion & Steve Durlauf eds., 2004).
14. Id. at 2.
15. INTERNATIONAL LABOUR ORGANISATION, EMPLOYMENT, INCOMES AND EQUALITY:
A STRATEGY FOR INCREASING PRODUCTIVE EMPLOYMENT IN KENYA 503 (1972) (first pub-
licizing the informal sector).
16. HERNANDO DE SOTO, THE OTHER PATH: THE INVISIBLE REVOLUTION IN THE
THIRD WORLD 19-55 (1989) [hereinafter OTHER PATH].
17. See id. at 158-60.
by using their property as collateral, causing that otherwise valu-

able property to be useless as an economic asset.18 Without title
to the property, the owner was unable to effectively hold out the
property against claims by others, had little incentive to improve
upon their property as there was no assurance that they would
be able to continue their occupation thereof, and were less likely
to invest in their property for personal use or to convert it into
some entrepreneurial use, such as a small home business or
storefront, since they had little security in their ownership.19 Ac-
cording to de Soto, the lack of property titles drained the econ-
omy of valuable economic resources, creating a pool of what he
called “dead capital.”20 His hope was that developing countries
would consider property titling programs, which would require
some type of land redistribution, in order to maximize the value
of all property in the state.
Informal labor, on the other hand, was also highlighted by
de Soto, but with very different causes and consequences.21 The
informal labor market consists of workers that do not maintain a
continuous formal job but that are in fact engaging in produc-
tive work.22 In some discussions, they are called “underem-
ployed,”23 in others, “working poor,”24 and still others, “informal
laborers.”25 They are not often regulated by the state and gener-
ally operate outside of formal legal constraints such as taxation
and labor laws, and also without access to health and unemploy-
ment insurance.26 They are generally paid significantly less than
formal workers, bear few of the benefits of formal work, and
have no opportunity for job training or education that might
18. See id.

19. See id.
20. MYSTERY OF CAPITAL, supra note 2, at 6.
21. Id. at 71 (speaking about the entrepreneurial opportunities of informal work-
ers and that they are largely prohibited by overregulation).
22. Id. at 28.
23. Franck Wiebe, Income Insecurity and Underemployment in Indonesia’s Informal Sector
3 (World Bank Policy Research, Working Paper No. 1639, 1996).
24. Martha Chen et al., Progress of the World’s Women: Women, Work & Poverty 12
(United Nations Development Fund for Women Report, 2005).
25. Colin C. Williams, Beyond Market-Oriented Readings of Paid Informal Work: Some
Lessons from Rural England, 65 AM. J. ECON. & SOC. 364 (2006).
26. See MARTHA CHEN, WOMEN IN INFORMAL EMPLOYMENT: GLOBALIZING AND OR-
GANIZING, THE BUSINESS ENVIRONMENT AND THE INFORMAL ECONOMY: CREATING CONDI-
TIONS FOR POVERTY REDUCTION 15, 17 (Oct. 2005), available at http://www.wiego.org/
publications/Chen%20Final%20Business%20Environment%20and%20the%20IE.pdf
[hereinafter BUSINESS ENVIRONMENT].
help them to improve their position or transition to other

work.27
One of the most prominent authors in the field of informal
labor markets, Martha Chen, explored this sector extensively
and recently identified the dynamic nature of the informal econ-
omy.28 She wrote that “the new definition of the ‘informal econ-
omy’ focuses on the nature of employment in addition to the
characteristics of enterprises.29 It also includes informal employ-
ment both within and outside agriculture.”30 Chen went on to
identify the reasons why development theories should be more
focused on informal employment: “[t]he recent re-convergence
of interest in the informal economy stems from the recognition
that the informal economy is growing; is a permanent, not a
short-term, phenomenon; and is a feature of modern capitalist
development, not just traditional economies, associated with
both growth and global integration.”31 It should also be noted
that the informal economy, while significantly larger in develop-
ing countries than in developed countries, is not absent from the
industrialized world. Saskia Sassen, among other prominent au-
thors, has highlighted the existence and growth of the devel-
oped country informal sector, often found in immigrant com-
munities that brought their home country practices to the devel-
oped world.32 The focal point of this Essay, however, will be on
the informal economy in developing countries.
The informal economy is growing.33 A recent Swedish In-
ternational Development Agency (“SIDA”) report found that
where economic growth is not accompanied by improvements in
employment and better distribution of gains, there will be a rise
in informal work, primarily through self-employed entrepre-
neurs.34 “In all developing countries, self-employment com-
27. Id. at 11-19.

28. Martha Chen, Rethinking the Informal Economy: Linkages with the Formal Economy
and the Formal Regulatory Environment 1 (2007) (Economic & Social Affairs DESA Work-
ing Paper No. 46).
29. Id. at 1-2.
30. Id.
31. Id. at 2.
32. Saskia Sassen, New York City’s Informal Economy, 4 INST. FOR SOC. SCI. RESEARCH 9
(1988).
33. Chen, supra note 28, at 2.
34. KRISTINA FLODMAN BECKER, SWEDISH INTERNATIONAL DEVELOPMENT COOPERA-
TION AGENCY, THE INFORMAL ECONOMY 3 (2004), http://www.sida.se/sida/jsp/sida.jsp?d
=118&a=3107.
prises a greater share of informal employment than wage em-

ployment.”35 The report goes on to conclude that more innova-
tive and supportive policies must be developed to focus directly
on informal work and workers.36 These self-employed entrepre-
neurs could productively contribute to the economy if they were
able to hold out their businesses as formal enterprises and count
on the protection of the state against competing claims to the
ownership of their store, corner of the sidewalk, or goods of-
fered for sale.
Informal property and informal labor comprise the infor-
mal economy.37 Few studies examine the interaction between
informal labor and property, and there is nothing that would
indicate a necessary linkage between living in untitled property
and working outside the formal economy. However, lack of ac-
cess to benefits, stable income, and the ability to use their em-
ployment as a security interest limit the ability of an informal
worker to obtain formal property. Both informal labor and in-
formal property can have negative effects on the growth of the
overall economy of a developing country.38
B. How is the Informal Economy Connected to the Rule of Law?

One of the principal concerns in development circles with
regard to the growth of the informal economy is the increase in
the number of people that are unable to rely on the state for
protection from trade shocks, labor crises, health emergencies,
and other significant concerns that would generally give rise to
some type of state protection.39 According to the World Bank,
“[t]he presence of a large fraction of the workforce in Latin
America that does not count on formal mechanisms to hedge or
mitigate these shocks is, hence, of intrinsic concern.”40 The
state serves to provide its citizens with public goods, such as
roads and defense, prevent social ills, such as health crises and
35. Id.
36. Id. at 3, 34.
37. Id. at 10.
38. See GUSTAVO MARQUEZ ET AL., INTER-AMERICAN DEVELOPMENT BANK, 2008 RE-
PORT: OUTSIDERS? THE CHANGING PATTERNS OF EXCLUSION IN LATIN AMERICA AND THE
CARIBBEAN 7 (2008); GUILLERMO PERRY ET AL., INFORMALITY: EXIT AND EXCLUSION 1-2, 7
(The World Bank ed., 2007), available at http://go.worldbank.org/ERL4C83K00.
39. See PERRY ET AL., supra note 38, at 22.
40. Id. at 22.
pollution, and provide for economic protections through regula-

tion, property rights, and the rule of law.41 Lack of access to
these public benefits can leave large swaths of people in danger-
ously insecure economic territory.
While there is some evidence of voluntary participation in
the informal economy, the decision to find work or property in
the informal economy is often the result of an inability to secure
work or property in the formal economy.42 High unemployment
rates in the formal sector combined with flexible labor practices
of formal enterprises lead many workers to seek alternative in-
come opportunities and many employers to recruit such work-
ers.
When citizens are forced, or choose to enter, the informal
economy to find work or property, they leave behind many of
the protections of the state. A job that a worker takes in the
informal economy is not generally regulated or protected by the
state.43 Accordingly, it does not provide benefits such as health
insurance, unemployment insurance, right of redress for labor
law violations, or benefits such as sick leave and skills training.
In the case of self-employment, for instance, which makes up the
majority of informal workers, a sick worker can mean the end of
their business endeavor.
Many of the least appealing jobs, such as street vending and
domestic service, are often filled by those with few alternative
employment prospects. Perhaps more significantly, the informal
economy is primarily occupied by the poorest citizens.44 Be-
cause informal work is unstable and unregulated, low wages and
lack of benefits maintain the limited individual economic growth
opportunities already endured by these workers. And because
informal property rights are limited, access to credit that might
be used to improve an individual’s economic situation is equally
limited.45 Add to this the failure of formal legal systems to pro-
tect the rights and enforce the duties of these individuals and
the result is what has been dubbed “social exclusion.” According
to the Inter-American Development Bank, “[s]ocial exclusion is
an inefficient and dysfunctional dynamic social, political, and ec-
41. Id. at 22-23.

42. See id. at 1, 6.
43. BUSINESS ENVIRONMENT, supra note 26, at 5, 8, 17.
44. Id. at 19-26.
45. See id.
onomic process whereby individuals and groups are denied ac-

cess to opportunities and quality services to live productive lives
outside poverty.”46
Rule of law programs have attempted to remedy some
problems with respect to judicial access, property rights, and
contract enforcement. These programs developed out of the
crumbling law and development movement of the 1960s, and
came on the scene in Latin America in the 1980s.47 The move-
ment gained momentum quickly, despite the uncertain linkages
between law and economic growth.48 Authors such as Thomas
Carothers, David Trubek, Alvaro Santos and Kenneth Dam, re-
cently provided substantive analyses and critiques of this linkage,
identifying past approaches to using law to promote economic
development and all generally concluding that it is a positive
and necessary, if uncertain, force in economic development.49 A
review of these works by Kevin Davis and Michael Trebilcock
concluded the following:
While there appears to be an increasingly firm empirically
grounded consensus that institutions are an important deter-
minant of economic development . . . there is much less con-
sensus on which legal institutions are important, given the ex-
istence of informal substitutes, what an optimal set of legal
institutions might look like for any given developing country,
or for those developing countries lacking optimal legal insti-
tutions (however defined) what form a feasible and effective
reform process might take . . . .50
One of the perceived barriers to the implementation of ef-
fective rule of law programs is the existence of an underground
economy that circumvents the law in its transactions. This infor-
mal economy comprises a substantial, if not a majority propor-
46. MARQUEZ ET AL., supra note 38, at 3.

47. See THOMAS CAROTHERS, PROMOTING THE RULE OF LAW ABROAD: IN SEARCH OF
KNOWLEDGE 15 (2006).
48. See, e.g., Davis & Trebilcock, supra note 1, at 51.
49. See Alvaro Santos, The World Bank’s Uses of the “Rule of Law” Promise in Economic
Development, in THE NEW LAW AND ECONOMIC DEVELOPMENT: A CRITICAL APPRAISAL 1-18
(David M. Trubek & Alvaro Santos eds., 2006); David M. Trubek & Alvaro Santos, Intro-
duction: The Third Moment in Law and Development Theory and the Emergence of a New Criti-
cal Practice, in THE NEW LAW AND ECONOMIC DEVELOPMENT: A CRITICAL APPRAISAL 253-
55 (David M. Trubek & Alvaro Santos eds., 2006); see generally CAROTHERS, supra note
47; KENNETH DAM, THE LAW-GROWTH NEXUS: THE RULE OF LAW AND ECONOMIC DEVEL-
OPMENT (2006).
50. Davis & Trebilcock, supra note 1, at 60.
tion of many developing country populations. It consists of indi-

viduals that transact business, including buying and selling prop-
erty and services, entering into contracts, and operating
storefronts; manage labor relationships; regulate real property;
and otherwise operate without the protection of the law. Access
to justice, facilitation of business, and control over disputes, are
part and parcel of an effective legal system, yet a large segment
of society cannot, or choose not to, resort to state-run institu-
tions. While early rule of law programs, dubbed the formalist
movement, pushed for better legal education programs, courts,
and other state-based institutions, individuals living and working
outside of formal constraints were all but ignored in their legal
needs. “[T]he formal legal system—the main focus of liberal le-
galism—was not accessible to the majority of the populace in
most developing countries.”51
As a result, social networks, community legal institutions,
and other informal legal organizations arose to provide protec-
tion where the state was absent, inefficient, costly or unreliable.
Social norms and culture served as bases for actions, and com-
munity members served as judges and juries. Property rights
were protected, contracts were enforced, and in some instances,
business transactions were regulated, by informal legal institu-
tions. The social norms and culture underlying these institu-
tions could be characterized, in the neoinstitutional context, as
part of the “rules of the game,” equivalent to formal law.52
II. INFORMAL LEGAL SYSTEMS
An informal legal system is a set of rules and guidelines by

which individuals respect and enforce the rights and responsibil-
ities of other individuals in situations that do not give rise to for-
mal legal protection.53 These systems are found in what de Soto
calls the extralegal sector, which he equates with the informal
economy.54 De Soto argues that, “[t]he extralegal world is typi-
cally viewed as a place where gangsters roam, sinister characters
of interest only to the police, anthropologists, and missiona-
51. Id. at 27.

52. DAM, supra note 49, at 66.
53. THE OTHER PATH, supra note 16, at 19.
ries.”55 Yet, he continues, this is the world in which the majority

of individuals operate, both socially and economically, and fail-
ure to address the pressing legal concerns of this population
risks the stability of the economic system as a whole.56
Informal law might be thought of as similar to traditional or
mercantilist law, which developed early in human history and set
the foundations for modern legal structures. Exchange was
based on trust and reputation and disputes were settled within
the confines of the community. As societies became more com-
plex, more extensive legal structures evolved from these tradi-
tional mechanisms, including administrative law, codes, and hi-
erarchies of legal authority. “Formal codified law emerges when
the social structure of a given society becomes so complex that
regulatory mechanisms and methods of dispute settlement no
longer can be dependent on informal customs and social, relig-
ious, or moral sanctions . . . .”57 Yet in many developing coun-
tries, factors such as the lack of central political control, unified
communities, and weak economic development, have prevented
them from fostering a formal legal system.58
A. The Pursuit of Justice

In some developing countries, especially those that did not
inherit or develop a strong rule of law system at their inception
as nation-states, citizens resort to traditional legal structures to
enforce their claims. This is especially true in states in which
state courts and judges are seen as corrupt, inefficient, or other-
wise costly.59 Citizens may “exit” the formal legal marketplace
when the institutions that would otherwise provide them reme-
dies are seen as ineffective, inefficient, and unfair.60 This ratio-
nale has been characterized as a dysfunctional social contract be-
55. Id. at 30.

56. See id. at 163.
57. STEVEN VAGO, LAW AND SOCIETY 39 (8th ed. 2006).
58. See Francis Fukuyama, Address at the IMF Conference on Second Generation
Reforms: Social Capital and Civil Society 4 (Oct. 1, 1999) (“The fact of the matter is
that coordination based on informal norms remains an important part of modern econ-
omies, and arguably becomes more important as the nature of economic activity be-
comes more complex and technologically sophisticated.”).
59. See, e.g., Thomas Barfield, Program Informal Dispute Resolution and the Formal Le-
gal System in Contemporary Northern Afghanistan 1, 11 (U.S. Inst. of Peace Rule of Law,
Draft Report, Apr. 21, 2006).
60. See PERRY ET AL., supra note 38, at 215.
tween citizens and the state, whereby public services that the
state is expected to provide in exchange for taxes and electoral
power, are ineffective or non-existent.61 A World Bank study
found a correlation between the effectiveness of government ser-
vices and the size of the informal sector.62 Lack of trust in the
government’s ability to provide for their citizens appears to drive
more people into informality.63 Estimates from the World Devel-
opment Indicators also identify a correlation between informal-
ity and weak rule of law in Latin America (Table 1).
Table 1. Informality and State Competence Indicators 64
Informal legal mechanisms work to facilitate property, contract,

and labor transactions in the absence of formal legal protec-
tions. If the costs of formal legal enforcement of property rights
are too high, the property is better off remaining in the extrale-
gal sector than being subjected to judicial review of ownership.
In the case of property, the extralegal sector fills the gap be-
tween formal rights recognition and simple possession, a grey
area in many developing countries. For contracts, it serves to
create binding obligations enforced via social trust networks
when judicial remedies are unavailable. And in the case of la-
bor, it creates employment relationships and informal obliga-
tions between employers and employees where formal contract
enforcement is unavailable.
61. See id. at 216.

62. Id. at 218, 220.
63. See id. at 218.
64. Id. at 221 (focusing study on Latin America and the Caribbean).
B. Protections Offered by Informal Legal Systems

1. Property Rights
When it is not possible to establish formal legal title to prop-
erty, institutional mechanisms can step in to provide a basic level
of recognition for that property. Communal property rights
serve as the informal mechanism for providing limited security
in informal property interests. Plots in many informal communi-
ties are carefully segregated and identified with one owner.65
Within that community, that owner enjoys benefits that might be
equivalent in some sense to formal title, including protection
against competing claims, incentive to invest time and resources
into maintenance and improvement of the property, and ability
to identify the property as collateral for local credit.66 The en-
forcement problem arises when that property is challenged by
the true legal owner or by individuals outside of the community.
Informal legal institutions can only protect property against
claims by those that recognize the informal occupier as the right-
ful owner.67 Thus, while the informal system provides limited
protection within the community, its geographic scope contin-
ues to restrict linkage with the broader economy, keeping any
economically productive use of the property limited in scope to
the community in which the occupying owner’s rights are recog-
nized.
2. Contract Rights
Informal legal mechanisms also serve to protect individuals
party to a formally unenforceable contract. Again, it is the en-
forcement of contracts and the resolution of contract breaches
that require some form of legal intervention—a basic offer, ac-
ceptance and performance without resulting disputes hardly
needs formal protection as the parties perform their duties with-
out objection. In the situation in which a dispute arises when
the parties are legitimately entering a contract and the subject
matter of the contract is legitimate, a court may serve as an effec-
tive resolution mechanism.68 However, cost prohibitions, lack of
65. MYSTERY OF CAPITAL, supra note 2, at 162; OTHER PATH, supra note 16, at 23-24.
66. See MYSTERY OF CAPITAL, supra note 2, at 183.
67. See OTHER PATH, supra note 16, at 161-62.
68. But note that even legitimate contracts may fail for lack of evidence. See id. at
163.
access to representation, and inability to attach assets for en-

forcement of judgments, can limit the value and thus the utiliza-
tion of this resource.69 Thus, social stigma becomes the enforce-
ment mechanism of choice in many informal communities. A
vendor who is a member of a community is unlikely to risk his
reputation by failing to perform his obligations under a contract.
The result would be a loss of respect and a subsequent lack of
business.70 Of course, this stigmatization would have little effect
if the contract is with a non-member of the community or if the
breaching vendor chooses to leave the community. But in the
instance of a vendor interested in maintaining his reputation,
the risk of lost business provides an adequate informal mecha-
nism to restrict his actions.
3. Labor Rights
Finally, in the informal labor market, informal legal mecha-
nisms serve to provide labor regulation to a minimal degree;
however, most of the issues that arise in this context can also be
covered by the contract discussion above. Many service provid-
ers, such as the transportation or microfinance industries, form
cooperatives to maintain consistent provision of services and to
limit overlap in the provision of services.71 These cooperatives,
like informal communities, have the ability to ostracize members
or take their routes away should they violate generally accepted
codes of conduct. What informal legal systems are unable to do
is to provide a system for the provision of fair wages, working
conditions, benefits, or training. The expansive amount of labor
available in developing countries provides a seemingly ceaseless
supply of cheap labor, meaning that any attempt to negotiate
fair wages and benefits on their behalf with willing employers
would be overcome by the availability of other sources of (non-
union) labor. Accordingly, informal legal institutions outside of
contract enforcement are less effective for labor contracts with
69. See MYSTERY OF CAPITAL, supra note 2, at 55-56 (discussing the risk of forfeiture
and other property seizure upon an enforceable judgment in Western legal systems).
70. See FRANCIS FUKUYAMA, TRUST: THE SOCIAL VIRTUES AND THE CREATION OF PROS-
PERITY 205 (1995).
71. ALLAN ROSENBAUM, COOPERATIVE DELIVERY OF PUBLIC SERVICES: REFLECTIONS
ON THE DYNAMICS OF PUBLIC SECTOR-–PRIVATE SECTOR-–CIVIL SOCIETY COLLABORATION
ON GOVERNMENTAL SERVICE DELIVERY 6 (2002) (noting the rapid increase in coopera-
tives between the state and the private sector).
the formal marketplace.72
III. WHAT INFORMAL LEGAL SYSTEMS DO NOT PROVIDE

The informal economy as a whole is largely and directly af-
fected by legal and regulatory systems that fail to provide several
things:
1. Adequate and affordable access to formal legal dispute
resolution mechanisms with the enforcement authority
of the state;
2. Accessible and efficient property registration processes;
3. Appropriate levels of regulation of the labor market;
and,
4. Recognition of informal property titles and contracts for
financial and legal transactions with public and private
entities.
Each of these concepts will be discussed briefly below.
A. Adequate and Affordable Access to Formal Legal Dispute

Resolution Systems with the Enforcement
Authority of the State
When a contract is drafted by an attorney in the United
States, the mindset of the parties is likely to be positive and look-
ing toward the benefits of the transaction that each hopes to
conclude in their interest. The mindset of the attorney, how-
ever, is on what will happen when something goes awry after the
contract has been signed. Preparing for disputes is part of the
contract drafting process, and identifying mechanisms to resolve
those disputes in advance is part and parcel of a good contract.
The result could be the inclusion of a binding arbitration clause,
forcing the parties to arbitrate all disputes rather than submit-
ting to the jurisdiction of a court, a liquidated damages provi-
sion, setting a specific amount to be paid in the instance of cer-
tain types of default, or perhaps a choice of forum clause, estab-
lishing a particular state, usually favorable to one of the parties
in interest, where all legal claims will be heard. Each of these
mechanisms serves to protect the parties in the instance of a dis-
pute.
In many developing countries, such dispute resolution
72. See Chen, supra note 28, at 8 (suggesting that while labor relationships do exist
between informal workers and the formal economy, they are often unregulated).
mechanisms are not as easily identifiable or accessible. Parties to

a contract drafted outside the formal legal system particularly
face substantial hurdles in enforcing their contract in the in-
stance of a dispute.73 Without formal recognition of contracts
drafted between parties for goods or services in the informal sec-
tor—such as a contract for the provision of labor at less than
minimum wage, or the unlicensed sale of commodities on the
street—a court is unlikely to enforce the terms against either
party. Contracts that are drafted between informal laborers and
formal or semi-formal enterprises have the additional problem
of adhesion contracting as the parties are of unequal bargaining
power and the informal party may have little ability to negotiate
or challenge the provisions of the contract.74 Additionally, the
informal laborer is less likely to have access to legal representa-
tion or finances to invest in the resolution of disputes with a
party that is more formally established and that has easier access
to such services.75
In place of formal dispute settlement mechanisms, many in-
formal economy contracting parties rely on social norms to en-
force the provisions of the contract. The loss of trust in a party
that breaches a contract can significantly affect that party’s fu-
ture business opportunities and may negatively impact their fam-
ily’s reputation in the community. This may serve as adequate
incentive to prevent the breaching party from avoiding the con-
tract obligation. Failure to carry out obligations under an infor-
mal contract can result in losses to one party, lack of trust in the
breaching party and perhaps their family, and potentially, vio-
lence.76
In other cases, parties require access to mechanisms beyond
social stigmatization. The community often has an informal dis-
pute settlement mechanism in place that the parties can access
when they cannot afford formal dispute resolution. Examples of
73. See Michael Trebilcock & Jing Leng, The Role of Formal Contract Law and Enforce-
ment in Economic Development, 92 VA. L. REV. 1517, 1519, 1522 (2006).
74. See Frank Garcia, Is Free Trade “Free?” Is It Even Trade? Oppression and Consent in
Hemispheric Trade Agreements, 5 SEATTLE J. SOC. JUSTICE 505, 512, 520-22 (2007).
75. For instance, under the Uniform Commercial Code, courts in the United
States may refuse to enforce any contract that is entered into unconscionably, that is,
unfairly. U.C.C. § 2-302 (2003).
76. See Trebilcock & Leng, supra note 73, at 1551-52, 1558-59; Guanghua Yu & Hao
Zhang, Adaptive Efficiency and Financial Development in China: The Role of Contracts and
Contractual Enforcement, 11 J. INT’L ECON. L. 459, 473 (2008).
such mechanisms from Kenya, Afghanistan, and Colombia are

below.
B. Case Studies on Dispute Resolution in Informal Legal Systems

1. Kenya
Research on informal dispute resolution systems in Kenya
led two authors to conclude that even informal dispute settle-
ment processes have their price.77 In Kenya, two distinct legal
processes are available to disputing parties. The first channel is
via the provincial administration, which was established during
colonial rule, and which allows for local resolution of disputes.78
This mechanism is less costly than state courts and utilizes par-
ties from within the community to serve as decision makers to
effectively settle conflicts.79 The formal mechanism constitutes
the second channel, which directs parties to state-sponsored
tribunals (e.g., land tribunals for property disputes) that consist
of representatives from each of the local districts.80 The latter
process is supported by the state and creates binding and en-
forceable outcomes. Because the state has sought to discourage
the use of informal dispute resolution mechanisms, decisions of
the provincial administration are non-binding and are not en-
forceable in court.81
Interestingly, the authors of On the Ege of the Law: The Cost of
Informal Property Rights Adjudication in Kisii, Kenya, conclude that
even though the informal process through the provincial admin-
istration is more affordable and accessible to those individuals
operating outside the formal economy, it is also increasingly per-
ceived as unjust and illegitimate due to perceived abuses of pro-
cess.82 This is one of the reasons that the informal process was
stripped of power to enforce decisions by the state. The authors
conclude that, while much literature supports the use of infor-
mal dispute settlement mechanisms, they may in fact be more
77. Elin Henrysson & Sandra F. Joireman, On the Edge of the Law: The Cost of Infor-
mal Property Rights Adjudication in Kisii, Kenya 5, 23, 25 (Mar. 26, 2008) (unpublished
manuscript), http://ssrn.com/abstract=1003427.
78. Id. at 7-8, 13.
79. See id. at 7-8.
80. The Land Disputes Tribunal Act, (1992) Cap. 21 §§ 4-5. (Kenya); Henrysson &
Joireman, supra note 77, at 7-8, 16.
81. Henrysson & Joireman, supra note 77, at 14.
82. Id. at 15-16.
costly in terms of rent-seeking opportunities of the decision-mak-

ers due to lack of a monitoring mechanism and the inability to
enforce decisions in state courts.83
2. Afghanistan
A draft report on the dispute resolution system in Afghani-
stan points to a problem that appears to arise in the instance of
post-conflict transitional states. The report discusses the sub-
stantial reliance upon informal dispute resolution mechanisms,
called shuras, despite the existence and availability of formal
courts.84 Individuals complained that the formal courts were
corrupt, costly, and inefficient, and judges were generally dis-
liked.85 The informal system was found to be quicker and
cheaper and thus more respected than formal mechanisms. The
shura system involves the selection of representatives from the
community, lending a degree of respect over the distant and
temporary relations of local judges.86 Decisions of these shuras
have the advantage of being registered with formal courts and,
in many cases, given formal legal effect.87 One judge noted that,
“[i]n most cases, we encourage people to solve their disputes
through local shuras and councils . . . . At the end we stamp the
arbitration paper as the representative of the court which gives it
legal value.”88 This process takes a significant case burden off
the courts and helps to facilitate the recognition of judgments.
However, it should be noted that one of the reasons the informal
and formal dispute resolution systems can function in tandem is
that they both rely on sharia law as the basis for their decisions.
Other developing countries in which customary rules relied
upon in informal dispute resolution procedures differ from for-
mal legal rules may have a more difficult time reconciling judg-
ments.
3. Colombia
Similar to Kenya and Afghanistan, Colombian citizens have
83. See id. at 23-24.

84. Barfield, supra note 59, at 2.
85. Id. at 1.
86. See id. at 2.
87. See id. at 2. But see id. at 4 (noting that business cases are not generally afforded
such legal recognition by the formal court system).
88. Id. at 4.
little faith in their formal judicial system. In a study of 4500 ru-

ral households across three Andean districts in Colombia, Edg-
ardo Buscaglia found that, like the rest of Latin America, Colom-
bia has an ineffective legal system that is ill-prepared for the de-
velopment of a strong private market economy.89 In his study,
he found that neighborhood councils, or parroquias vecinales,
were used more than twice as often as formal court mechanisms,
and that their decisions enjoyed a high-level of legitimacy due to
the fact that they are constituted by prominent local residents.90
Like the shura decisions in Afghanistan, decisions of parroquias
vecinales are generally given tacit approval by municipal authori-
ties, allowing local government enforcement of their decisions.91
Buscaglia’s study sheds additional light on the subject of ac-
cess to dispute resolution mechanisms by inquiring of residents
what obstacles prevent them from seeking formal dispute resolu-
tion. The vast majority of residents complained of a lack of in-
formation about their rights and obligations under the law as
preventing their access to formal justice.92 The three culprits in
Afghanistan and Kenya followed in the Colombian survey re-
sponses—direct costs, delays, and corrupt practices.93 Interest-
ingly, the Colombia study evaluates the net worth of residents
before and after accessing formal legal channels for dispute reso-
lution by measuring change in household income and assets.
The study concludes that the poorest ranks of the population
are negatively impacted economically when they try to resolve
their disputes formally, which may be attributed to high court
costs and delays in resolving pressing disputes. Buscaglia calls
this a “regressive tax on those households within the bottom net
worth range.”94
The focus of acquiring access to dispute resolution mecha-
nisms should be both on evaluating the effectiveness of informal
mechanisms to determine their viability and whether their deci-
sions can and should be enforced in formal courts, and also on
89. EDGARDO BUSCAGLIA, JUSTICE AND THE POOR: FORMAL VS. INFORMAL DISPUTE
RESOLUTION MECHANISMS: A GOVERNANCE-BASED APPROACH 5 (2001), http://sitere-
sources.worldbank.org/INTJUSFORPOOR/Resources/JusticeandthePoorFormaland
Informal.pdf.
90. Id. at 8-9.
91. See id. at 9.
92. Id. at 11-12.
93. Id.
94. Id. at 15-16.
providing more effective and affordable access to formal courts

by reducing filing fees, providing a sufficient cadre of public de-
fenders, and limiting damages against indigent parties. Access
to formal dispute resolution mechanisms may be necessary in or-
der to effectively enforce judgments and seek resolution of more
serious legal complaints. However, use of informal dispute reso-
lution channels appears to bypass legitimate concerns over costs,
delay, and corruption in formal dispute resolution systems and
reduces the caseload burden on formal courts.
C. Accessible and Efficient Property Registration Processes
In developed countries, we often take for granted the pro-

cess of registering a business, transferring a title to property, or
even renewing our driver’s license. These processes are the re-
sult of years of legislative and regulatory modifications that
sought to streamline administrative processes and reduce bu-
reaucracy. The fluidity to which many of us have become accus-
tomed differs substantially from the cumbersome and often
time-consuming administrative process in developing countries.
Hernando de Soto conducted independent surveys of the regis-
tration and operation of a business in Peru in order to confirm
his suspicions that the process in developing countries was too
complicated and overregulated.95 The results were clear and
provided strong evidence that overregulation was stalling the re-
gistration of businesses and, according to de Soto, discouraging
some individuals from operating formally at all.96
Recent World Bank reports continue to confirm de Soto’s
conclusions about the regulatory processes in developing coun-
tries—the time that it takes to register a property in many devel-
oping countries is substantial in comparison to the process in
developed countries. A sampling of countries ranked by ease of
doing business and organized by property registration rank is
listed in Table 2 below.
95. OTHER PATH, supra note 16, at 148-51.

96. See id. (discussing the costs of remaining or becoming a formal business).
Table 2. Property Registration Number of Procedures and Rankings

(World Bank Doing Business 2007). 97
Ease of Doing
Economy Business Rank Registering Property
Singapore 1 13
Iceland 10 8
Belgium 19 161
Puerto Rico 28 117
Spain 38 42
Armenia 39 2
Botswana 51 36
Mongolia 52 18
Colombia 66 69
Jordan 80 109
Nicaragua 93 130
Russia 106 45
Bangladesh 107 171
Uganda 118 163
Tanzania 130 160
Sudan 143 32
Afghanistan 159 169
Sierra Leone 160 172
Eritrea 171 158
Venezuela 172 74
Congo, Dem. Rep. 178 141
To highlight the difference between the higher and lower

rankings in terms of property registration, we can note that in
Singapore, it takes roughly nine days and three procedures at a
cost of 2.8% of the property value to register property; in Colom-
bia, it takes twenty-three days and nine procedures at a cost of
2.5% of the property value; and in the Democratic Republic of
97. WORLD BANK, DOING BUSINESS 2007 (2006), http://www.doingbusiness.org/

documents/DoingBusiness2007_FullReport.pdf.
Congo, it takes fifty-seven days and eight procedures at a cost of

9.7% of the property value.
Yet even if the registration of property is efficient and af-
fordable, many individuals operating informally are occupying
land that is not theirs (squatting) and thus will have to pursue
legal action to quiet title in order to determine the proper
owner of the property. Some development economists have ar-
gued that the most effective way to achieve economic develop-
ment in terms of property rights is to allow the most productive
user of the property to acquire title.98 Even if this procedure
were applied, formal legal procedures would need to be estab-
lished to ensure that the true owner of the property is duly noti-
fied and compensated, potentially by the state, and that conflicts
over ownership between the owner, law enforcement, and the
occupier, do not impede redistribution efforts.
D. Appropriate Levels of Regulation of the Labor Market

Hernando de Soto argued that the reason people function
outside the formal legal system in a developing country is di-
rectly linked to the costs of operating formally. According to de
Soto, ineffective administrative and legal mechanisms force peo-
ple into extralegal relationships.99 Martha Chen takes this analy-
sis deeper by linking the nature of employment relationships to
the state of the regulatory structure. She finds that informal
work is either disguised deliberately in order to avoid recogni-
tion of a legal relationship; ambiguous, as in the case of a street
vendor selling goods as an agent of a distributor; or not clearly
defined, as would be the case in most sub-contractor relation-
ships.100 None of these employment relationships provide labor
law protections for the employee, yet firms relish the opportu-
nity to utilize these informal workers because they come at a sig-
nificantly lower cost and with less need for long-term employ-
ment contracts than do formal sector workers.101 As employ-
ment opportunities decline in many developing countries, more
98. See generally Ronald H. Coase, The Problem of Social Cost, 3 J.L. & ECON. 1 (1960)
(arguing that the efficient allocation of property rights will have the most beneficial
effect on reducing economic transaction costs).
99. MYSTERY OF CAPITAL, supra note 2, at 18-21, 156.
100. Chen, supra note 28, at 8.
101. See id. at 9.
workers find it necessary to find this survival work, despite the

costs.
Chen agrees with de Soto that overregulation plays a major
role in impeding employment in the formal economy.102 But
she also finds that the opposite can be true. Lack of regulation
can be just as costly to economic development. As an example,
she asserts that many cities do not have any laws regulating street
vending, allowing law enforcement to deal with them as they see
fit, which tends to exacerbate the problem rather than working
with street vendors to ensure their safety and economic pro-
gress.103 Rampant corruption combined with low wages for law
enforcement officers results in routine bribery and facilitation
payments made by informal operators.104
Following the logic of Martha Chen, Emilio Klein and
Victor E. Tokman explain the need for employers to have flexi-
bility in their hiring and employment of laborers.105 Klein and
Tokman argue that employers are interested in bypassing labor
regulations in order to maintain responsiveness to changes in
labor costs and demand for their goods and services.106 Yet
Klein and Tokman make clear that we must recognize the dis-
tinction between the existence of regulatory frameworks on the
books and the state’s willingness or interest in enforcing those
frameworks.107
Accordingly, thorough examination of the regulatory envi-
ronment in which informal labor markets operate is a crucial
area to address. Flexibility is a key facet of effective labor market
regulation because it can limit opportunities of employers to
take advantage of unregulated labor, while at the same time free-
ing them to expand their cadre of workers formally without be-
ing forced into excessive employment relationships when their
need is short-term.108
102. See id.

103. Id.
104. See id.
105. See generally Emilio Klein & Victor E. Tokman, A Comparative View of Regula-
tions and Informality, in REGULATION AND THE INFORMAL ECONOMY: MICROENTERPRISES IN
CHILE, ECUADOR, AND JAMAICA (Emilio Klein & Victor E. Tokman eds., 1996).
106. See id. at 33.
107. Id.
108. See Chen, supra note 28, at 9 (suggesting the firms prefer informal workers in
order to avoid strenuous regulated labor contracts).
E. Recognition of Informal Property Titles and Contracts for

Financial and Legal Transactions with
Public and Private Entities
Hernando de Soto opens his book, The Other Path, with a
story about the transportation industry in Peru and how many
rural areas that needed access to the city for work were unable to
find adequate transportation due to their remote location and
the limited availability of buses.109 A group of informal entrepre-
neurs recognized this problem and formed a cooperative to try
to service the necessary routes with adequately-sized vehicles.110
As the popularity of such services grew and the city continued to
be unresponsive to the needs of its rural citizens, the cooperative
sought to purchase over 100 buses, but they lacked an effective
mechanism to finance the purchase.111 They had no titles to
their homes or to any of their personal possessions that could be
used as collateral, no bank accounts, and no formal credit.112 In
the end, a foreign financial institution, Deltec Banking Corpora-
tion, provided them with sufficient funding to purchase buses
for the routes using the buses as collateral and listing the new
owners’ informal property titles as evidence of property owner-
ship.113
The fact that informal communities lack formal titles should
not signify to the world that they are not the owners of their
property. But the lack of formal title is evidence of substantial
lending risks for banks and credit institutions as there is no way
for them to ensure that their property could actually be signed
over to the bank upon default and that their contract would
even be enforceable in court. In most developed countries,
processes for title searching are commonplace and are used by
all lending institutions considering the provision of collateral to
guarantee a loan.114 Such searches are less common in develop-
ing countries and, even if they did exist, they would be unlikely
to result in the recognition of the informal property holder’s
name in the record as they are only occupying the property.
However, the use of informal networks and organizations as
109. OTHER PATH, supra note 16, at 118, 121.

110. Id. at 121.
111. Id.
112. Id.
113. Id.
114. MYSTERY OF CAPITAL, supra note 2, at 63-65.
a substitute for the state in conducting business transactions is

growing. As informal organizations become accepted by a larger
constituency, comprise a larger portion of the informal econ-
omy, and provide access to a greater amount of information, re-
liance upon such organizations to reduce the costs of con-
ducting business is becoming commonplace. The World Bank
has emphasized its focus on law as an institution conducive to
economic change, rather than the state.115 In order to conduct
business outside the strictures of state institutions, where the
bulk of those in greatest need of legal and economic protection
reside, informal institutions can serve as a valuable substitute for
formal law.116
What is largely absent from many formal legal systems in
developing countries today is formal recognition of property ti-
tles and judgments set forth by informal legal organizations.
The need for credit to invest in businesses and basic home im-
provements, education, and health care is clear. Accordingly, a
system of informal title recognition should be developed in
which the state or a third party can rely on informal title records
and community affidavits to provide a guarantee that can be
used to secure credit. These guarantees could be backed by the
full faith of the government to repay the loan if necessary. They
could provide much needed access to credit and they would con-
vert an informal legal institution—reputation and trust—into a
formal legal tool—collateral. The ability of a party to enforce
judgments or seek remedies for breaches of contract regulated
by informal legal organizations in the formal legal environment
is a key element in the provision of security for investors. Recog-
nition and enforcement of such judgments may build a bridge
between informal businesspeople and their formal counterparts.
IV. THE POTENTIAL FOR DEVELOPMENTAL GAINS FROM

INFORMAL LEGAL INSTITUTIONS
There is potential to rely on informal legal institutions as a
form of precedent for formal legal mechanisms. In the case of
115. See generally World Bank, Law and Development Movement, http://sitere-
sources.worldbank.org/INTLAWJUSTINST/Resources/LawandDevelopmentMove-
ment.pdf (last visited Sept. 19, 2008).
116. See Kerry Rittich, The Future of Law and Development: Second-Generation Reforms
and the Incorporation of the Social, in THE NEW LAW AND ECONOMIC DEVELOPMENT: A CRIT-
ICAL APPRAISAL 224-25 (David M. Trubek & Alvaro Santos eds., 2006).
property, this could mean that recognized property titles in in-

formal communities would be able to serve as evidence and per-
haps as a sufficient basis for providing formal legal protections
against competing claims and for granting formal title. With re-
spect to contracts, decisions of community councils and other
informal enforcement bodies could serve as evidence of the exis-
tence of a valid and enforceable contract in the formal court
system, allowing the court to effectively enforce judgments of
those informal bodies. And in the case of the labor market, em-
ployment relationships that have existed informally may serve as
a reasonable basis to extend formal labor rights to the employee
upon the showing of certain factors, perhaps including a mini-
mum length of employment, minimum working hours, and a
willingness to continue such employment by both parties. By
creating legislation that authorizes the use of informal property
titles, contracts, and labor relationships as precedent for formal
legal enforcement a bridge is built between the formal and infor-
mal economies, allowing for a limited degree of integration of
the two markets and moving toward broader formalization.
Supplanting often ineffective and incomplete informal en-
forcement mechanisms with the force of formal law is likely to be
beneficial to economic development and growth; however, ig-
noring the existing informal legal institutions could be a costly
mistake as it sacrifices an existing body of law that relieves inves-
tigators and legal professionals of significant fact-finding mis-
sions to identify proper titles, contract relationships, and labor
arrangements, for instance. Existing legal structures serve a valu-
able purpose not only to maintain order outside formal eco-
nomic relations, but also as a bridge between informal and for-
mal enforcement of the law. “No law is better than another, as
long as it is able to regulate relations between people or commu-
nities, protect the weak and establish a degree of equity in the
way the society functions.”117
The World Bank recently moved away from a formalist con-
ception of the rule of law and instead embraced the possibility of
engaging the informal legal economy:
A new conventional wisdom about the rule of law and devel-
opment seems to have taken root in development circles. It is
117. Posting of Abdou Diouf to Ideas for Development, http://www.ideas4devel-

opment.org/justice-and-development/en/ (Feb. 27, 2008).
asserted that formalist rule of law, which stresses institutional-

ized legal mechanisms and absolute autonomy from politics,
is a necessity for economic development. But attempts to
transplant formalist rule of law to developing and/or democ-
ratizing countries could actually be counterproductive for ec-
onomic, institutional, and political development, especially
when informal mechanisms would be more effective and effi-
cient.118
A. The Role of Institutions in Development

Douglass North argues that institutions are essential for eco-
nomic development, including not only law and social norms,
but also customs and unwritten codes of conduct.119 North sug-
gests that institutions are the “rules of the game” that allow trans-
actions to take place and that these rules can be measured in
terms of transaction costs and efficiency.120 In addition, North
found that the two types of institutions—formal institutions,
such as an existing legal system, and informal institutions, such
as codes of conduct or cultural norms—work together in most
societies to provide necessary incentives and limits on behav-
ior.121
Enforcement of law requires not only law enforcement per-
sonnel, but also a certain level of awareness of, respect for, and
understanding of the law. If the law is ineffective or does not
serve the needs of the people, it will be exceedingly difficult to
enforce. “Substantive rules on the books do not capture the es-
sence of a legal system.”122 Enforcement of laws may be even
more important to economic development than the existence of
substantive law itself.
Kenneth Dam asserts that “rule-of-law institutions are not es-
sential for economic activity (although they are relevant to eco-
nomic growth).”123 To ensure productive foreign trade, contract
enforcement and property protection are essential. Transition
118. World Bank, Law & Justice Institutions, Rule of Law and Development, http:/
/go.worldbank.org/MX64OQ3EU0 (last visited Sept. 19, 2008) [hereinafter WB, Law &
Justice Institutions]; Trubek, The “Rule of Law” in Development Assistance: Past, Present,
and Future, supra note 6, at 90-91.
119. North, supra note 7; see also, DAM, supra note 52, at 22.
120. North, supra note 7.
121. Id.
122. DAM, supra note 52, at 23.
123. Id. at 70.
to rule-of-law in most states has been an evolutionary process.

“[N]o degree of improvement in substantive law—even world
‘best practice’ substantive law—will bring the rule of law to a
country that does not have effective enforcement.”124 Without
effective legal institutions, Kenneth Dam argues, such as the ju-
diciary, changes in substantive law make little difference.125
North argues that institutions “form the incentive structure
of a society” and that these in turn are the foundation for eco-
nomic performance.126 Institutions consist of formal and infor-
mal constraints and their enforcement characteristics. They de-
termine the transaction costs, which constitute part of the costs
of production. Only when there are no transaction costs are in-
stitutions unnecessary. Because economic markets are imperfect
and include high transaction costs, institutions matter.
North finds that the rational-choice framework in economic
theory only holds water in the context of individual decision-
making in highly developed societies.127 It does not function in
environments of uncertainty, especially within markets in transi-
tion. Growing interdependence among people spurs the need
for more complex institutions to capture potential gains from
trade. Yet it is important to note, as North does, that “econo-
mies that adopt the formal rules of another economy will have
very different performance characteristics than the first econ-
omy because of different informal norms and enforcement.”128
Accordingly, endogenous growth of complex institutions may be
the most effective contributor to overall economic growth.
These increasingly complex institutions that North refers to
may in fact be reflected in the existence of informal legal sys-
tems. There is a growing recognition that civil society organiza-
tions and social networks may serve a valuable purpose in provid-
ing for the legal demands of citizens that otherwise do not have
access to formal justice.129 Formal legal institutions may not be
necessary for a society to function properly in a global market-
place. “Rather than the antithesis of law, now informal norms
may supplement or even supplant formal law in the facilitation
124. Id. at 93.

125. Id. at 95.
126. North, supra note 7, at 1.
127. Id. at 3.
128. Id. at 5.
129. See generally WB, LAW & JUSTICE INSTITUTIONS, supra note 118.
of business transactions.”130 This is a significant change in previ-

ous thinking about the rule of law and has given rise to a num-
ber of important ramifications. The role of law in development
may be multi-faceted and complex, operating both at a formalis-
tic level within state-based institutions that govern transactions
similar to developed countries, as well as an informal level where
informal institutions, social networks, and civil society organiza-
tions develop or inherit rule-based structures that provide the
equivalent of state-based protection, yet outside the state struc-
ture.
Informal institutions serve to fill the supply gap of formalist
law, yet they also reflect a distinct approach to the provision of
justice. They operate at the community level, giving them some
sense of additional credibility, and serve equitable as well as judi-
cial remedies. In the interest of community cohesion and devel-
opment, these informal institutions are in a better position to
use law as a redistributive tool, whereas formal institutions are
bound to constrain their decisions to formal law.131
Some theorists, especially those interested in East Asian
growth, have concluded that formal legal institutions have little
role to play in development.132 Rather, they contend that infor-
mal social networks and systems of dispute resolution can have
the most dramatic effect on economic growth. “[I]nformal
mechanisms that recognize and protect private property rights
and ensure performance of contracts are often effective substi-
tutes [for formal law].”133 However, it has also been asserted
that once a country reaches a certain stage of economic develop-
ment, formal mechanisms play a more substantial role in contin-
uing the developmental trajectory.134
North believes that a key facet to good development policy
is the development of flexible institutional structures that adapt
to their particular environment.135 Informal legal systems may
well provide the flexibility needed to meet the demands of the
informal legal marketplace. For North, the need for institutions
130. Rittich, supra note 116, at 224.

131. See, e.g., id. at 225.
132. See, e.g., KATARINA PISTOR & PHILIP A. WELLONS, THE ROLE OF LAW IN ASIAN
ECONOMIC DEVELOPMENT (1999).
134. See generally DAM, supra note 52.
135. North, supra note 7, at 6, 367.
arises due to high transaction costs.136 Law, as an institution,

reduces transaction costs by reducing the risk for the parties to a
transaction. Security in the outcome and potential remedy for
breach of an agreement, for instance, makes individuals more
willing to enter into subsequent agreements. In societies in
which formal law does not provide this security to individuals or
is ineffective in what it does provide, informal legal institutions
step in to mitigate the risk and continue business as usual.
Accordingly, the value of informal legal institutions may be
equally important in terms of economic development as is the
establishment of formal institutions. Rule of law practitioners
and institution-oriented economists would do a disservice to de-
veloping countries if they were to ignore the importance of these
institutions to economic development.
B. Limits on the Practicality of Informal Legal Systems

Informal legal systems are not appropriate for all cases.
While they are likely more effective at resolving most civil dis-
putes involving land, family, contract, and tort law, and may be
effective in managing some criminal cases, they are unlikely to
be effective in resolving cases involving deprivation of liberties,
serious criminal cases requiring state punishment, and cases in-
volving foreign law or parties.137
“Property is not a primary quality of assets but the legal ex-
pression of an economically meaningful consensus about assets.
Law is the instrument that fixes and realizes capital.”138 Focus-
ing on this legal identity behind the assets, contracts, and labor
relationships, will help us to understand the legal intricacies of
economic exchange. What this Essay has presented is a system of
alternative law, a mechanism that exists in the formal and infor-
mal economy, and one that can be capitalized upon in order to
extend the reach of the rule of law.
The principal issue raised in this Essay is whether there ex-
ists, in addition to an informal economy, an informal legal sys-
tem intended to fill the void left by the ineffective formal legal
system in developing countries. And if such a system exists,
should the system be exploited through a process of unifying
136. See id. at 2, 360.

137. See, e.g., BUSCAGLIA, supra note 89, at 20.
formal legal institutions with informal legal operations, should

informal decisions be given no formal weight, or should jurispru-
dence outside of formal state-sanctioned institutions serve as per-
suasive, or even mandatory authority?
CONCLUSION
Informal legal systems fill the void in property recognition,
contract enforcement, and in some cases, labor rights, for those
individuals unable or unwilling to avail themselves of formal le-
gal enforcement. Recognition and utilization of this informal
mechanism to help us determine the identity of property owners
and the existence of informal contract and labor relationships
can help legislators build effective formal legal institutions that
encompass the full range of legal relationships in developing
countries.
The majority of literature on rule of law and institutions
suggests that the law has an important role to play in guiding
economic development. However, as Kevin Davis and Michael
Trebilcock conclude in their survey of the field, there is no cer-
tainty as to what that role is and which legal institutions in partic-
ular play the most important part in economic development.139
This Essay suggests that informal legal institutions play a key role
in providing access to a substantial portion of the population
that otherwise would have no formal legal options. Accordingly,
while their impact on economic development directly is uncer-
tain, their importance in informal communities is indisputable.
Broader recognition of the role played by informal legal mecha-
nisms and enforcement of informal legal body decisions has the
potential to further reduce transaction costs between individu-
als, which may in turn facilitate the expansion of economic op-
portunities through investment, credit arrangements, and small
business development. Thus, the formal recognition and en-
forcement of informal legal rights and decisions appears to have
a positive role to play in economic growth and development.

Role of Informal Legal Institutions in Economic Development

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txt unknown Seq: 1 22-DEC-08 13:49

THE ROLE OF INFORMAL

* Adjunct Professor of Law, American University Washington College of Law; Asso-

Electronic copy available at: http://ssrn.com/abstract=1144643

2 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

ity of such rights, there is no practical value in having title to

Electronic copy available at: http://ssrn.com/abstract=1144643

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 3

When we begin to examine how legal reform can be pro-

8. International Labour Organisation, Committee on Employment and Social Policy Re-

4 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

efficient allocation of resources will prosper.”14 While economic

Fundamental Cause of Long-Run Growth, in HANDBOOK OF ECONOMIC GROWTH 1 (Philippe

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 5

by using their property as collateral, causing that otherwise valu-

18. See id.

6 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

help them to improve their position or transition to other

27. Id. at 11-19.

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 7

prises a greater share of informal employment than wage em-

B. How is the Informal Economy Connected to the Rule of Law?

8 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

pollution, and provide for economic protections through regula-

41. Id. at 22-23.

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 9

onomic process whereby individuals and groups are denied ac-

46. MARQUEZ ET AL., supra note 38, at 3.

10 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

tion of many developing country populations. It consists of indi-

II. INFORMAL LEGAL SYSTEMS

An informal legal system is a set of rules and guidelines by

51. Id. at 27.

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 11

ries.”55 Yet, he continues, this is the world in which the majority

A. The Pursuit of Justice

55. Id. at 30.

12 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

Table 1. Informality and State Competence Indicators 64

Informal legal mechanisms work to facilitate property, contract,

61. See id. at 216.

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 13

B. Protections Offered by Informal Legal Systems

14 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

access to representation, and inability to attach assets for en-

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 15

the formal marketplace.72

III. WHAT INFORMAL LEGAL SYSTEMS DO NOT PROVIDE

A. Adequate and Affordable Access to Formal Legal Dispute

16 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

mechanisms are not as easily identifiable or accessible. Parties to

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 17

such mechanisms from Kenya, Afghanistan, and Colombia are

B. Case Studies on Dispute Resolution in Informal Legal Systems

18 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

costly in terms of rent-seeking opportunities of the decision-mak-

83. See id. at 23-24.

2008] INFORMAL LEGAL INSTITUTIONS IN ECONOMIC DEV. 19

little faith in their formal judicial system. In a study of 4500 ru-

20 FORDHAM INTERNATIONAL LAW JOURNAL [Vol. 32:1

providing more effective and affordable access to formal courts

C. Accessible and Efficient Property Registration Processes